Engr 2 – Engineering Economics
Module No. 5
This module will cover the following topics:
Nominal rate of interest
Effective rate of interest
Continuous compounding
Doubling and tripling time of investments
5.1 Nominal rate of interest
Nominal rate of Interest (NRI or r) – is the one quoted in describing a variety of compound
interest. It specifies the rate of interest and the number of interest periods per year
𝑟 = 𝑖𝑚
Where:
i = interest rate per period
m = number of periods
Thus, a nominal interest rate of 6% compounded monthly simply means that there are 12 interest
period each year. The rate per interest period being:
𝑟 6%
𝑖= = = 0.5%
𝑚 12
5.2 Effective rate of interest
Effective rate of Interest (ERI) – is the actual interest earned in one-year period.
𝐸𝑅𝐼 = (1 + 𝑖)𝑚 − 1
ERI for continuous compounding:
𝐸𝑅𝐼 = 𝑒 𝑟 − 1
EXAMPLE:
1. Find the nominal rate compounded monthly which is equivalent to 12% compounded quarterly.
SOLUTION:
*Equate the ERI for compounded monthly which is equivalent to 12% compounded quarterly.
𝐸𝑅𝐼𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 = 𝐸𝑅𝐼12% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦
𝑟 12 12% 4
(1 + ) − 1 = (1 + ) −1
12 4
𝑟 12 12% 4
(1 + ) = (1 + )
12 4
𝑟 12
(1 + ) = 1.12550881
12
12 𝑟 12 12
√(1 + ) = √1.12550881
12
𝑟
(1 + ) = 1.009901634
12
𝑟
= 1.009901634 − 1
12
𝑟 = (1.009901634 − 1) × 12
𝒓 = 𝟎. 𝟏𝟏𝟖𝟖 𝒐𝒓 𝟏𝟏. 𝟖𝟖%
2. If a nominal interest rate per year is 12% and compounding is continuous, what is the effective
interest rate per year?
SOLUTION:
*Solve for ERI using the formula:
𝐸𝑅𝐼 = 𝑒 𝑟 − 1
𝐸𝑅𝐼 = 𝑒 12% − 1
𝑬𝑹𝑰 = 𝟎. 𝟏𝟐𝟕𝟒𝟗 𝒐𝒓 𝟏𝟐. 𝟕𝟓%
3. If P1,000 becomes P1,811.36 after 5 years when invested at an unknown rate of interest
compounded bimonthly, determine the unknown nominal rate and the corresponding effective rate.
Given:
P = P1,000
F = P1,811.36
t = 5 years
m=6
SOLUTION:
*Solve for the nominal rate (r) using the formula:
𝑟 𝑚𝑡
𝐹 = 𝑃 (1 + )
𝑚
𝐹 𝑟 𝑚𝑡
= (1 + )
𝑃 𝑚
𝑚𝑡𝐹 𝑚𝑡 𝑟 𝑚𝑡
√ = √(1 + )
𝑃 𝑚
𝑚𝑡𝐹 𝑟
√ = (1 + )
𝑃 𝑚
𝑚𝑡𝐹 𝑟
√ −1=
𝑃 𝑚
𝑚𝑡 𝐹
( √ − 1) × 𝑚 = 𝑟
𝑃
6×5 1,811.36
𝑟=( √ − 1) × 6
1,000
𝒓 = 𝟎. 𝟏𝟏𝟗𝟗 𝒐𝒓 𝟏𝟐%
*Solve for the effective rate of interest using the formula:
𝐸𝑅𝐼 = (1 + 𝑖 )𝑚 − 1
12% 6
𝐸𝑅𝐼 = (1 + ) −1
6
𝐸𝑅𝐼 = 𝟎. 𝟏𝟐𝟔𝟏𝟔 𝒐𝒓 𝟏𝟐. 𝟔𝟐%
5.3 Continuous compounding
The concept of continuous compounding is based on the assumption that cash payments occur
once per year but compounding is continuous throughout the year.
𝐹 = 𝑃𝑒 𝑟𝑡
𝑃 = 𝐹𝑒 −𝑟𝑡
Where:
F = future worth
P = present worth
r = nominal rate of interest
t = number of years
EXAMPLE:
If the nominal rate of interest is 3%, how much is P5,000 worth in 10 years in a continuously
compounded account?
SOLUTION:
Given:
r = 3%
P = P5,000
t = 10 years
*Solve for the future worth using the formula:
𝐹 = 𝑃𝑒 𝑟𝑡
𝐹 = 5,000𝑒 3% ×10
𝑭 = 𝑷𝟔, 𝟕𝟒𝟗. 𝟐𝟗
5.4 Doubling and tripling time of investment
Doubling Time – the time required for an initial single amount to double in value with compound
interest.
log 2
𝑛=
log(1 + 𝑖)
Tripling Time – the time required for an initial single amount to triple in value with compound
interest.
log 3
𝑛=
log(1 + 𝑖)
General equation:
log 𝑘
𝑛=
log(1 + 𝑖)
Where:
k = 2, 3, 4…
EXAMPLE:
1. How long will it take for an investment to double its amount if invested at an interest rate of 6%
compounded monthly?
SOLUTION:
*Solve for the time it takes to double the investment using the formula:
log 2
𝑛=
log(1 + 𝑖 )
log 2
𝑛=
log(1 + 6%)
𝒏 = 𝟏𝟐 𝒚𝒆𝒂𝒓𝒔
2. How long will it take money to triple itself if invested at 8% compounded annually?
SOLUTION:
*Solve for the time it takes to triple the investment using the formula:
log 3
𝑛=
log(1 + 𝑖 )
log 3
𝑛=
log(1 + 8%)
𝒏 = 𝟏𝟓 𝒚𝒆𝒂𝒓𝒔